ECB QE: will it happen and what next?

Markets’ initial response to Mario Draghi’s Jackson Hole speech has been to inch up the probability that the European Central Bank will finally enact full-blown quantitative easing, or large-scale asset purchases, although the ECB president’s speech was sufficiently Delphic to cover a wide range of possibilities.

With valuations in some markets at record levels, particularly European government bonds, it is at least as important to consider how markets are likely to react if and when QE is announced, as it is to consider the likelihood of the announcement itself.

We were told at Jackson Hole that the ECB governing council would “acknowledge” that medium- and long-term market-implied inflation expectations are becoming unanchored; and Mr Draghi also expressed a new, softer stance on fiscal austerity.

But the governing council can hardly deny that markets are pricing in ever-lower inflation expectations. And rather than implying some sort of joint easing (fiscal stimulus matched with more monetary stimulus), the softer stance on austerity may be presented as a new additional reason for the ECB to hold off from full-blown QE.
QE or not QE?

So Mr Draghi’s speech may presage the announcement of QE. But it is equally compatible with the continuation of the existing ECB stance that the measures already announced at the June meeting (the negative deposit rate, targeted longer-term refinancing operations, and eventual asset-backed securities purchases) have the capacity to be effective and need time to work, with QE as a tool in reserve.

While the path of ECB policy remains unclear, the extreme levels of European government bond markets demonstrate growing doubt that the ECB will deliver the policy response needed to revive growth in the euro area.

Market pricing of future inflation has also moved to levels suggesting scepticism that the ECB will meet its inflation target over a two- five- or 10-year horizon.

As a result, yields on 10-year German Bunds have fallen below 1 per cent – nearly 150 basis points below equivalent US Treasuries. This is close to the widest negative spread since the euro was introduced. Spreads of less than 50 basis points above 10-year Japanese government bond yields are also the lowest positive spread in 30 years or more. This is a market pricing in convergence towards a deflation scenario, not economic revival.

The fall in Bund yields has dragged down yields on other European sovereign bonds, which on the face of it is encouraging. But it is notable that peripheral sovereign 10-year yield spreads versus Bunds are above June’s levels. That implies an increasing credit risk premium.

For the moment, the core-peripheral risk premium is still capped by the low level of bond yields around the world, as well as by the prospect of support from the TLTROs (cheap loans available to banks), and of full-scale QE if necessary.

But look ahead: within months, Federal Reserve QE will end; within a few quarters, the Bank of England and the Fed will probably have started raising interest rates; uncertainty regarding take-up of the TLTROs will persist; and if the ECB again postpones QE, market scepticism is unlikely to decrease. Ultimately, it seems it will become increasingly risky for the ECB to continue to postpone QE.
Market reaction

So what will be the markets’ reaction if ECB QE is announced? Given the record valuations already reached, some of the responses may be the opposite of what one might normally expect.

The US and UK experience is that the announcement of QE raises inflation expectations and cuts real yields, overall reducing nominal 10-year yields. But because the ECB has waited so long to act, both 10-year break-even inflation and 10-year real yields are already much lower than they were in the US when the Fed started its QE programmes.

An announcement of ECB QE is likely to raise inflation expectations much more than it would lower the real yield, meaning the nominal 10-year Bund yield would rise rather than fall, by 40-50bp. At shorter maturities (up to five years), though, the yield curve would remain flat, anticipating that policy rates will stay low for years after the inception of QE, as has been the case in the US, UK and Japan.

For the eurozone periphery, QE would see 10-year yield spreads over Germany fall to about 100bp as credit risk premiums diminished. But with Bund yields rising, this spread narrowing would probably not result in any meaningful fall in peripheral 10-year yields from their present levels.

Finally, it is likely that ECB QE would be moderately bearish for US and UK government bonds, as the prospect of effective stimulus for the euro area would remove one of the impediments to the normalisation of rates in the US and UK.


Laurence Mutkin is global head of G10 rates strategy at BNP Paribas


Fonte: FT